Jason Hartman: Hey, it’s my pleasure to welcome Tony from Cleveland calling in and he’s got a very good question about inflation and more specifically target inflation. Tony, how are you?
Tony: Good. How are you doing, Jason?
Jason Hartman: Good, good. It’s great to talk with you and thanks for calling in to the show. So tell me what is on your mind?
Tony: Well, you know, my question revolves around inflation. And I hear you talk about a lot on your show. And I know you talk about investing in multi-unit properties and single family real estate as well and you call them package commodities and this helps to pace with inflation and the expected inflation that you see coming. You know, my concern is – and I have two duplexes in which I hope, you know, I’m doing the right thing with my investments. I love my duplexes. They give me cash flow. In long term, I really hope that they do well for me but what I’m concerned about – I hear you talk about it a lot is – you talk about inflation and I’m concerned more about target inflation. And what I mean by that is the Fed as you know, they take inflation, they measure it in a different kind of way. They use kind of an accordion feature in which they take items in and out of the inflation pool.
Jason Hartman: Let’s just explain that a little bit for the listeners. That’s the basket of goods, so to speak, the CPI or the consumer price index uses and, of course, like you said, they take things in and out – that’s called substitution. And they also weight things differently – that’s called weighting. And so they weight, they substitute, and then they apply hedonics to which we have talked about on prior shows, too. So, yeah, go ahead with the target inflation question.
Tony: Basically, what I’m getting at is, you know historically, a lot of our people’s income usually gets sliced up in a pie of their budget. In historical terms, a large portion of that pie has been all used for rent and any kind of that instrument like a mortgage or . . .
Jason Hartman: Your housing cost in other words.
Tony: . . . or even a car, for an example. But, you know, in historically, what we’ve seen I think is a large portion of the consumers’ budget being appropriated towards those things but has – I’m starting to wonder if we’re starting to see maybe something a little different as far as maybe, you know, are the consumers going to be constrained where you see certain items becoming hyper inflated and even to see a bigger inflation rate on things that you totally use like electric, gas, water, sewer. And I talk about these in historical terms, those have always been a really small portion of the American’s budget. But my concern is – here in Cleveland, for example, the sewer rates are astronomical and they laid out like the rates are going to go up exponentially over the next ten years. And that’s really going to push for the ceiling and the amount of rent that I’m thinking you’d might be able to get long term, you know, those kind of increases. Is that going to kind of, I guess . . .
Jason Hartman: Is it going to derail your investment. Sure. OK. Let’s talk about a couple of things here. First of all, so when you talk about target inflation, who causes target inflation? Are you saying that the Fed can actually control which things inflate more than others? I mean, I first want to kind of smoke that part of the question out and then I want to talk about utilities or certain things rising and other things falling or staying even.
Tony: You know, I’m not seeing so much, you know, target per se, the Fed goes and says we want this type of commodity to raise – I’m not talking about that. I’m talking about more because the scarcity of resources, specifically with the global economy, you got China, India becoming big players, especially for energy. Are those demands going to really inflate especially as more people come out of poverty across the world? You’re going to have a huge demand on natural gas, oil, you’re starting to see that. Is this going to push constraint on the amount of rent you’re going to be able to charge and the value of houses for that matter?
Jason Hartman: It’s a great question. Now, let me address it. I don’t know what your point was there but let me just kind of make it a little more succinct if I may, OK? So here’s the thing. Personally, I think energy cost will continue to rise and as they rise, that will actually increase the cost of those what I call package commodities or houses because energy cost is in every single product and service we buy. Energy is everywhere. It’s omnipresent. And so, if the cost of energy goes up, the cost to build a house goes up. Now granted your thinking is very interesting because what you’re saying is if the cost of energy goes up a lot, will that curb the ability for me to charge more rent in the future for my properties?
Tony: And not just that. The price of houses and commercial buildings, are they going to be able to go up at the same rate and increase if you can get a loan or the cost of that loan is going to be such that it is going to put constraint on a budget, any kind of budget like a household, especially more for the single-family house perspective.
Jason Hartman: Let’s not go into the loan and financing because that is sort of a different discussion. Let me just address the energy part, OK? I say, and you know again, this is just my feel about it and my prediction. I could be wrong, OK? But I say, I’m pretty sure I’m going to be right about this one that the higher the cost of energy goes, the higher the cost of housing will go because it costs more to build a house, to build an apartment building and it’s going to cost more to build it and own it, it’s also going to cost more to rent it. Here’s what declines. What declines as these things go up and food will cost more – energy will make everything cost more. If energy is more expensive, everything else is pretty much more expensive, too. But here’s the thing. The thing that will suffer, where does the money come from if people have to pay more for food, if they’ve got to pay more for utilities, if they’ve got to pay more for all of the goods and services that are derived from energy and energy is a component of all those cost, then here’s where the money comes from. It comes out of the standard of living. The standard of living is what suffers and declines. And I’ve said it many times, look at it like two ladders, OK? And this is the best way I can think of to visualize it. There’s probably a better way. But if you look at the tenants you have, you have two duplexes now. And your tenants that live in those duplexes, they have been – throughout their adult lives and, well, their childhood, too, but let’s just take their adult lives – they have been at different levels of the socioeconomic ladder. Sometimes, they’ve had a great year and they’ve been doing really well and they’ve got more money to spend and they live in a nicer, better, bigger place in a better location. Other years, things aren’t going so well, they’ve got less money to spend. They live in a smaller place. They live in an inferior neighborhood and they live in an attached house rather than in a detached house. So, this varies throughout one’s life. But where the cost will come from is it will come out of the standard of living. So, if your tenant lived once in a 3,000 ft.2 house in a nice neighborhood, they may in the future, as these cost rise, live in a 12,000 ft.2. house in a lesser neighborhood. That’s where the cost comes from. And the reason I know this is because if you look back in like – I’ve lived my childhood, I grew up in Los Angeles and in my adult life, I pretty much lived in Orange County which is about 40 miles south of L.A. And there’s an area there, Newport Beach which I’ve lived in Newport Beach, Irvine, et cetera. And in Newport Beach, there’s this really nice upper class neighborhood. It’s called Harbor View Homes. In Harbor View Homes, those homes I think were built in the early 70s. And I think and I could be wrong in this but I remember I did study it before and I really thought a lot about it many years ago. So don’t quote me on the exact numbers but I’m just giving you the concept. But I think when those homes are built in the early 70s, you could buy one for like $42 – $62 something around there, OK? And here’s the deal. They started, I think, the smallest home in there is like maybe 1,600 ft.2 and then there are larger ones. And it’s a really nice neighborhood. It’s got a school down the middle. It’s nowadays, it’s like to keep up with the Jones yuppy neighborhood, everybody’s driving a Range Rover and trying to outdo each other and everybody went to USC and UCLA and all these stuff, right? But here’s the thing. The funny thing is that you see all of these studies they quote: OK. Americans are living better than they ever have because the typical home built after World War II was 900 or 1,200 ft.2 or whatever it was, right, when all the people came back and the economy started to boom after World War II. And now, the typical home is much larger than that. It’s maybe, I don’t even remember the number, it’s maybe 2,200 ft.2 And you think by looking at that, not knowing any better and this is why you can’t just look at a book or a Website. You have to think about these things and be experienced in the market. But what they didn’t tell you in that is how much smaller the average yard got and how much denser the people started living. They started living like rats, stacked on top of each other in high density housing developments. Yes, the unit they lived in might have gotten larger but the yard and the piece of land that they had with it and the location of that property got smaller and lesser and inferior. So, it’s not just about the square footage of the unit. It’s the whole picture. If you lived on a 10,000 ft.2 or 12,000 ft.2 lot in Harbor View Homes in this area of Newport Beach versus living in, I’ll just take for example another of Orange County, in Garden Grove, you might live in a larger home but just doesn’t make sense when you look at these studies, you know …
Tony: I get what you’re saying. You can actually look at – one thing I find fascinating is around here in Cleveland, there’s old homes here. You got homes from the early 1900s and one thing that just kind of shows how we’ve, I guess, grown as a society or how we have so much disposable income is look at the closet space. You go into . . .
Jason Hartman: Right, good point.
Tony: . . . a 1900 home, a closet is one door. Then all of a sudden in the 70s, you saw the two-door closets. Now you got walk-in closets. So, people are having more and more disposable income and buying more and more things. And I guess my point is, for example, utility bills in my area, we’ve just become deregulated here and you’re starting to see a lot of electric and gas companies. You can pick your own service and you pay. And what they kind of done is they’ve upped the fix rate, usually, in the past, the fix rate has always been really low. But they’ve upped the fix rate to say, a minimum of $25 for gas up here in Northeast Ohio. In the summertime, it’s usually pretty cheap and your gas bills will be pretty low. But now, they’ve jacked the fix cost up to $25, right. So now – and they’ve lowered the cost per unit of utility. But I have a feeling over time, those things are going to start to go up. And that’s going to put pressure on how much more rent I’m going to be able to raise because typically in the past, you know, you’d figure three percent inflation, I can boost my rent depending on the area, four to five percent. But my theory is the utility companies are going to say, you know what, we’re going to get rid of the sliced amount and we’re going to start increasing our rates and it’s going to really tamper. It’s funny – my buddy, he works for the sewer district and his famous quote is, “You know what, someday, you’ll going to have to choose over cable or your sewer bill. That’s how’s it going to be in the future.” In a way, I kind of laugh, and I’m like, you know, he’s probably right. They’re just going to jack the rates up so high. And one more thing, you’ve talked about the taxes and obviously, that’s a whole different discussion how we’re so much in debt but what municipalities are starting to do is they – because they own these sewer districts or these regional or these water districts, they’re passing on the tax base that they’re missing out into these utilities to try to get extort more money out of people, you know, because they can’t get into the tax base.
Jason Hartman: Right. So I say, one day you’re going to have to choose not just between like your friend’s as your cable and your sewer bill but you’re going to have to choose between a bigger house or a smaller house, an older house or a newer house, a better neighborhood or an inferior neighborhood, and that’s the choice everybody has to make today. But the standard – what is going to happen in America, and it’s already happening and it’s been happening for years, is the standard of living is going to decline. It has to. I mean, folks, the only thing that can really rescue us from this and here’s where it’s the wildcard, and it’s what I don’t know and I hope I’m totally wrong about it – the thing that could save us all is technology. I have a friend who is a young guy. He’s like 23 and he just moved here to Phoenix from Dallas. He’s actually my neighbor. And he works for this energy company and they think, they have like solved the energy problem. And they’ve got this little black box and they say, and I don’t know how it works, I even have him talk to one of my energy friends who was in the energy business and he couldn’t figure it out either. They say they’ve got this little black box that more energy comes out than goes in and it doesn’t split atoms, OK? It does it through magnetism somehow. And, you know, look at it, if this is true, if some incredible technology like – some incredible way to produce energy is discovered or invented, or some incredible biotechnology or nanotechnology or whatever that solves big, huge problems, I mean if someone masters the energy problem for example, energy is going to be the biggest industry on the planet, I would assume, that would be the world’s first trillionaire. You think Bill Gates and Warren Buffett are rich? No. The energy person is going to be the trillionaire, the first trillionaire, right? And so, that would be massively deflationary initially. I mean if energy got super cheap or free, remember I had Steven Kotler on the show who wrote the book Abundance along with Peter Diamandis. That’s a few episodes ago. You know, one of the things they talked about in that book is how the prediction was that electricity would become so cheap that it wasn’t even worth metering. It wasn’t even worth keeping track, just give it to everybody for free. Now that didn’t quite happen but compared to the olden days, it really did happen because electricity is still pretty darn cheap, OK, even though it’s gotten more expensive in recent years. So we don’t know. The technology thing is a total wildcard.
Tony: Right. And to that point, you know, I guess you can say, with technology – and that’s another aspect of the whole inflation because I guess, my whole, circling back to my whole point was – is inflation and energy cannot put deflationary pressure and house appreciation and commercial building appreciation and rents, is that where we’re going to see forward, you know. And to that point, I guess you got to bring in supply. Now, I know you’ve seen household formation has been really pretty stagnant since the great recession but – I guess that’s a really great hope is, there has been zero new builds as constructions really coming to a halt so you’re going to have this real constraint on supply and I think what everybody’s thinking going forth, is going to happen, is all of a sudden you’re going to have all these household formation, you’ve got lack of supply and it’s going to drive values up. I think that’s kind of what everybody’s done at. But, from the technology standpoint, people are starting to work from home now and you’ve got a lot of office buildings, you have a lot of once-retail space, once-warehouse space and now those are – I think they’re going to be existing units, they can be converted into housing. You start to see it all over the inner city and urban areas already. The point, you know, do we have enough supply out there that it’s really going to knock weak that inflation that we’re hoping for and instead push the deflationary pressure that’s another tool that’s going to happen as the years go on.
Jason Hartman: OK, so we’ve got numerous issues here we’re talking about, OK, and we just can’t cover them in a short conversation, however. Maybe you want to call in again and we’ll talk about some of those other issues especially the financing one. I’d love to tackle that one as well, you know, the money supply issue that you kind of alluded to earlier. But first of all, I have long said that – I’ve been saying this for, I don’t know, 8+ years at least, OK, that housing is where it’s at because fortune 1,000 companies are telling people to work out of the house, they can outsource the call centers to India, that’s office space. Then outsource coding to India, Ukraine, Russia, for software that’s office space. They can outsource manufacturing to China and other countries, that’s industrial property. They can outsource shopping to the Internet and that is retail centers. So I completely agree that housing is where it’s at. Now, what you said was really a conversation you were about and what you said about construction because construction is definitely ramping up. I am looking out my window right now. I live in the tallest all-residential building in the state of Arizona and I’m looking out my window right now and I see two big, giant cranes that are building high rise buildings and they’re residential high rise by the way, not office. So I would not touch office space, I wouldn’t touch retail, I wouldn’t touch industrial, I’m all about housing. And the population has been increasing pretty dramatically in the past few years although household formation has not because Gen Y is the boomering generation. They’re living at home, they’re having a hard time but ultimately, they will move out. Some moved up a lot. Many people will have roommates for much longer than they used to and, you know, that’s all part of the standard of living declining. That’s just all part of it. But ultimately, household formation is increasing, that is the trend. I mean it has to. People can only live at home for so long, people eventually are going to move out, get married, have kids, granted they’re doing it much later. But you know what they do in the process of waiting for that to happen is that they rent, they don’t buy. So – but to answer your fundamental question of this phone call is that as energy prices rise, construction cost rise, the cost of creating all those raw materials that are the ingredients of house whether they’d be concrete, milling lumber, producing glass, steel, copper wire, petroleum products – all of that is energy. And as energy becomes more expensive, so does building. And if building gets too expensive, then they stop building and less people can afford to pay for it. So, you have all these interplaying factors but remember my concept that I’ve talked about on prior episodes about the three dimensions of real estate. And there are really more than three but I call it the three dimensions because it’s a catchy title. So the rental market and the for sale market are most of the time countercyclical because when it’s too expensive to buy or there’s a lack of financing, or the rates are too high on mortgages, or the building cost is too high, people are forced into the rental pool when it’s easy to buy and so prices generally are suppressed to buy properties. But rents are counter to that. They’re countercyclical. These are non-correlating indicators because the rents go up as long as the population isn’t declining. That is the one thing that really, really would derail my theory and that’s why states like your state and states like Michigan that generally are losing population, that are not business-friendly like California, I don’t like those areas that much because you’ve got to have population growth for my whole theory to work. Like, if we didn’t have population growth, I would have a completely different opinion of how these should all go, OK, and if we didn’t have spending. Now, to get back on that energy thing just for a second, say this kid and his company – it’s not his company but he is one of the engineers, like leading this project – say this kid and his company solved the energy crisis problem. I thought a lot about that since I met him and talked to him about what he’s doing, and if the energy problem is solved at first, I think it would be very deflationary. Any great new technology like that would be deflationary. However, I wonder, and I don’t know the answer, nobody really does but I kind of speculate, if energy got super cheap, ultimately, that would lead to an era of just unbelievable prosperity. And prosperity creates inflation. So initially, I think there will be deflation but after the prosperity started just coming in to the global system in every human being was enriched to dramatically – I mean you think globalization hasn’t reached 275 million people and pull them out of poverty – Wow, you haven’t seen anything yet. If energy was free or super cheap, I mean it would pull everybody out of poverty. Everybody would be prosperous. It would be amazing. And prosperity creates inflation so it’s all a cycle. So, I don’t know what would happen but you know, it’s just like . . .
Tony: I think if that were true, if energy were to become super cheap, I think you’d really see other things obviously become a lot more expensive, for example, rent because – again, the household budget, I really think you can make that a bigger piece of your expenses if you can decrease other areas of where most family spent.
Jason Hartman: Interesting topic and interesting question, Tony. I got it. Hey, my pleasure. I got to ask you. How did you find our podcast and how long have you been listening?
Tony: You know, I’ve been listening to tell you, about three years now. I found you on iTunes and I’ve been listening ever since.
Jason Hartman: Well, fantastic. Thank you for listening and please spread the word and tell your friends. I appreciate . . .
Tony: Sure, I will, yeah. I mean, I’d like to get another conversation with you about cap rates because I fundamentally disagree with you a little bit there but that’s a whole different topic we can talk about maybe some other time.
Jason Hartman: Gosh, you know what, that’s probably a quick one. Let’s talk about it. What about cap rates?
Tony: Well, you know, to me, the evaluation of a property is ultimately determined by the kind of rent and the kind of income you can produce – you can get from it. So obviously, in low cap rate areas such as New York City, you’re going to see three to four percent cap rates. Even in California at one time, they had four percent cap rates.
Jason Hartman: Oh, they had less than four . . .
Tony: The whole idea is it’s a better area, kind of like interest, you know on a city. Obviously that’s protected by the FDIC, is going to get a lower rate because there’s less risks. So low cap rates generally, I guess, can be interpreted as low risk so people are going to pay a premium for that if you can get the kind of rent and the kind of income from it. So that means there’s competition, that’s where’s driving price up, there’s I guess – into that is priced in a revenue stream that’s going to increase at a greater rate. So people are going to pay, you know, premium to kind of get into those kind of deals to begin that kind of action.
Jason Hartman: OK. Well, so that’s an interesting perspective and I’ve never heard it expressed that way before. So, you are right that in expensive areas with high land values like California and New York, cap rates are very, very low. I think those areas are terrible places to invest. The reason is cap rates are very low, meaning your cash and cash return is going to be low. A trophy property like if you were to buy a Trump tower in the middle of Manhattan in New York City, the cap rate on that would be lousy. And you’re right, competition does drive cap rates down.
Tony: But if I think about it in a way, think about where that competition’s coming from though, you’re talking a highly educated demographic, you’re talking great access to usually education and you know, people want in on those kinds of markets. You got great jobs and income and all those things that, you know, there’s so much driving into that price up, people want in on that, you know, and…
Jason Hartman: Oh, wait a sec, wait a sec.
Tony: … and those things don’t have value, right, I mean if you have a highly educated workforce, you have great company paying good wages and for the foreseeable future, they’re going to be paying better wages like San Francisco for example, people want to get in on those areas and they’re going to pay a premium to get on them. I mean if you lever it up a hundred percent, then all a sudden, your cash and cash return looks kind of impressive.
Jason Hartman: Well, but it will look more impressive in an area with a better cap rate. I mean I don’t think that theory holds water at all because first of all, those areas – the land and the prices of the properties are too expensive, the people that are going into those properties are highly educated, you’re right. But they are the institutional Wall Street style investors. Those are the ones accepting those lousy cap rates and we’ve talked about this on the show many times. Number one, it’s not their money. They will bend over backwards to squeeze thirty basis points out of a deal. I mean it’s incredible. They’re like grabbing the crumbs on the table compared to the kind of returns individual investors get. They can’t manage a fragmented asset class like we can as individuals. So it doesn’t work for them.
Tony: There are so many billions of dollars on the sideline even after these deals. I mean if I got a billion dollars in a bank and I need to allocate that capital, where am I going? I’m not going to Pulse, Oklahoma, you know with the ten cap rate or 14 cap rate. I’m going into where I know that money is probably is going to – definitely have a better chance of increasing in value than it does. I guess it all just all comes down to pricing. Yeah, you know, you can take the higher cap rate, you’re taking a little more of the risk whereas a lower cap rate, you’re taking a little lower risk as far as the fundamentals of what drives rent, what drives appreciation and some of those things.
Jason Hartman: I disagree fervently and here’s why.
Tony: You’re kidding me.
Jason Hartman: No. I’m not kidding you at all. OK, listen. I’ve lived my whole life in California. I’m abundantly familiar with trophy properties that my friends have purchased in places like La Hoya and Newport Beach and Irvine and I think they’re out of their mind. And the reason is because they – you’re saying that you think that’s a speculator’s gain. You’re thinking that those properties will appreciate and they have done that in the past, I’ll give you that. But I don’t think the future of those markets is very good at all. If we are really in for a bad swag in the economy, granted it will look like and it will fool people into thinking there has been appreciation, but that appreciation will be a nominal, not real dollars because there has been overall inflation, that boring property in Texas just churns out cash flow. And I’m a cash flow investor. If you or any of these other people are speculative investors – and listen, I have made lots of money speculating, don’t get me wrong. If I can buy a property like I’ve purchased properties in Newport Coast before, Newport Coast, California, a very high end area, and I’ve lived in them and sold them just a year or two later, and you know I got another $300,000 give or take out of that property, that was a great deal. But could I depend on that? Did I know that was going to happen? Absolutely not. I got lucky. And I’d rather be lucky than good any day of the week. Sure. But I like cash flow …
Jason Hartman: … you got tons of land right? I mean there’s a lot of land, as far as I can see, so you’re always going to have the risk of supply. Now you’re going to Metro Manhattan, it’s all the factors, no land. So, you’re going to, you know, if you want in. And back to demographics, for example, you have a younger generation who aren’t even buying cars. I just read 50% of 18-year-olds don’t even have a license. So, they’re willing to live urban in the city and guess what they’re not going to have a car payment so maybe they can pay that higher premium and rent and going forward. They can allocate more of the money towards them. And I think that people are looking at that whole, all those cash backs and they will pay a premium to go to those places where there’s so much scarcity of supply. And future supply is kind of thwarted down especially with what you said in California, you got building codes, things like that, which just makes it very difficult to build and to bring in new supply whereas you go into taxes, I can go in there with a few buddies and a toolbox and probably start, you know, building some houses if I had a little cash on me.
Jason Hartman: No, no, you can’t. You’re wrong, OK, and here’s why — because we don’t invest for land value. Our land is free on the stuff we buy. Who cares about the land? It doesn’t matter to me if there’s a zillion acres of vacant land because we’re buying package commodities. I mean you understand that, you opened this call with that question.
Tony: Oh, right. No, no, yeah, that’s what I’m saying. When you have area for growth, if you have areas where you can build a lot more houses or new builders can come in, these institutional investors can come in and start building them up, the properties…
Jason Hartman: But that’s not the point.
Tony: … you know, you’re going to build a good increase of supply, you’re going to be able to increase the supply and drive down prices where if you were in Manhattan – and that’s the whole, I think, fundamental of the cap rate because people are paying these premiums because they know where else you going to go, you know, who else is going to – nobody’s going to build in New Jersey, you know, tomorrow they’re not going to be able to clear out side buildings and put in new apartments, you know, it’s going to take a lot of resources to do that so people are willing to buy these turn key like you say, you know, ready houses or in a big city like that.
Jason Hartman: You’re not seeing the picture. Yes, an institutional builder can come in and build on all these vacant lands but so what? They had to pay for construction materials. That’s the whole point of my philosophy. You’re investing in commodities, not land. I have said it many times before. I hate real estate. I don’t even like real estate. You know what I like? I like commodities tied to 30-year fix rate debt. So if these institutional investors want to go in and act like idiots and buy three and four cap properties, let them do it all day long. You know why they don’t care that much? First of all, it’s not their money. It’s someone else’s money. Institutional investors like trophy properties and I say to you, trophy properties are not where the money is at unless you have massive appreciation and speculative bubbles. And those do happen and they have happened but they are highly risky. We’re very conservative here. We just want to be in a situation where we can buy properties that produce cash flow. What I meant to do . . .
Tony: Jason, I totally agree with you, you know, don’t get me wrong. I’m not saying – it’s I’m just trying to, you know, and I think you understand the philosophy behind these low cap rates. Do the numbers make sense for you and I or a lot of investors out there? No. And should we be investing in those kind of properties? I would say no. But when you’re talking, people with hedge funds with billions of dollars and they need to employ and they need to engage with that capital, that’s where they go.
Jason Hartman: I know they do. I agree.
Tony: Not for you and I. But I’ll go battle it out. Do these returns make sense? No, but I think from that kind of investor, that’s how they get these cap rates.
Jason Hartman: Yeah, the reason they get those cap rates down is – You know Warren Buffett really pretty much summed it up, I mean, we’ve quoted him so many times on the show talking, making that quote from a few months ago when he said, “If I could figure out how to buy a couple of 100,000 or a couple of million single-family homes and figure out how to manage them, I would do it.” But they can’t, they can’t compete in our fragmented business. And that’s why the opportunity is here for us, not for them. And by God, I hope they can never institutionalize it. They’re trying. I mean there are hedge funds buying it up swaths of every single-family homes now. I don’t think it’s going to go that well for them. I think they’re just going to get tired of the fragmentation and managing. I mean, how many people do you know that rent a single-family home that sends the rent check to some sort of hedge fund? Probably nobody right? But you’re going to start seeing a little bit of that mostly what they’re doing is buying and flipping and they’re just dicing up large portfolios and the smaller ones and selling them off and taking a profit there. But yeah, we don’t compete with the institutional investors. You know, I remember one of my friends sold a big apartment complex, I think, in Aliso Viejo, California, nice area, a nice suburban area, and it’s called The City Lights and I think that complex one for like 90 million dollars or some huge price. And what’s the cap rate, forgive me because I can’t remember but it was low. The cap rate was like 4.5. It was terrible. I’m thinking, I would never do that deal. But if they’re buying properties with cash and they don’t need cash flow because they’re not going to get it, they can do that kind of premium stuff, you know, it’s just a different type of investor. The people listening to this show aren’t those people and I’m not one of those people. And I want cash flow. I want conservative stuff that just spins off cash and if it appreciates, hey, that’s the icing on the cake. This has been an interesting discussion, what do you think?
Tony: Yes, yes. Great, that was great. You know, I love the engagement. Just to give you a background, you know, I bought two duplexes back when the market was almost on the peak. I bought one in 2005 and one in 2008 so I got one that’s kind of peak at the market and one in a down in the market. The good thing is I got them in for closure. They were _____ [00:37:28] properties. So I was able to buy it at a discount, they were in good areas with low competition as far as – there weren’t many duplexes in the city that I bought them in and there are very good schools, you know …
Jason Hartman: But there’s the thing. You’re really giving me answer here. If you bought properties that made sense the day you bought them, one of my ten commandments, “Thou shall not gamble.” In other words, the cap rate was probably eight percent or better because that means the property have cash flow. If that cap rate is that good, who cares if the value goes down? You can weather almost any storm. If things get bad and the property depreciates in value, as long as you can maintain that income-expense ratio, hey, you can just sit there and weight it out. And I saw that happen for over 20 years as I saw the Irvine company, a big famous company owned by Donald Bren, one of the Forbes 400 richest people in America, there in Southern California. They were all over but mostly in Southern California. And I’ve done lots of business with him over the years. I saw them in their residential, in their commercial properties. They will just weight the market out. There are premium, high priced, high end developer and manager of properties and if you’ve got a property that makes sense and the reason it makes sense for them is they got the land so cheap so many years ago that their bases in there are so low that they can just weight. If you’re a big fat institutional investor with loads of cash and you could weight, hey, the only way we as individual investors can afford to weight is by having a property that cash flows the day you buy it. That’s all that works for them but yes, it’s interesting background. What else do you want to say on that point though?
Tony: In rehab, I was able to rehab, I did it on myself so I was able to save a lot of money on my upfront cost. My cash and cash return is much better because I was able to do the improvements myself. So even when the market went down on the downside, that basically hedge my back because I didn’t pay top dollar for an older style house where I was able to buy at the bottom and put in new fresh finishes at a high end place. So I was able to, you know, that helps when I try to rent it out and things like that. It kind of gives me a competitive advantage. So, my goal is like yours, Jason, I just want to light this thing out and when I’m older, just keep the cash flowing, keep it going, you know, and being able to collect my rent. I just want to see appreciation on both sides. I want to see appreciation and rent which I think we’ve all seen in the last couple of years. But, you know, I would also like to see appreciation on the asset side as well. That would be, like you said, the icing on the cake. But even if it’s not there, hey, so be it as long as I can get appreciation as far as rents, I’m going to be a happy man.
Jason Hartman: Just remember one thing about that is that you’re really unlikely and we’re all unlikely to see real appreciation. Most appreciation is just a result of inflation. It’s an illusion. You don’t really see it much in real dollars. Sometimes you do but no one depend on that one at all. But if the commodities keep pace with inflation, but the debt is destroyed faster by inflation and if you have leverage by say putting 20% down, you’re really beating the inflation rate by a 5:1 ratio because you only paid 20% of the asset’s cost. So if the asset keeps pace with inflation then it’s only even, right? If inflation goes up at three percent and the property goes up at three percent, in real dollars, you’ve only treaded water, you’ve done nothing. However, if you leveraged it, all you do is you multiply that three by five and that gives you, what, it gives you 15 and you’ve outdone inflation by 5:1 ratio. So you’ve made money there and at the same time, the debt, see that’s leverage but then there’s inflation induced destruction. It’s getting destroyed by the inflation and hopefully, your rents are going up. That, my friend, is a beautiful equation. Well, hey, thank you so much Tony for calling in and I appreciate the heated debate. I love being challenged on my ideas, OK? So listeners, heed that call. If you’ve got a question out there or you want to challenge me on an idea – you know, it’s great, it makes me think about it. It’s kind of like exercise. You got to exercise your brain and your ideas, so I totally appreciate it and call in again, OK?
Tony: Sure. Thank you, Jason.
Jason Hartman: All right, my friend, happy investing.
Tony: Thank you. Take care.
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Jason Hartman: It’s my pleasure to welcome Larry Muck to the show. He’s the executive director of the American Association of Private Lenders. And you know, in the real estate industry and the private lending industry, it’s a very fragmented business as we all know and I’ve talked about many times on the show. And there are some organizations cropping up here and there to try and organize things a little bit more and this is one of them. Larry, welcome. How are you?
Larry Muck: Thank you very much. I’m great today.
Jason Hartman: Good. Where are you located?
Larry Muck: I have quarters in Kansas City. We moved the headquarters in the business from Raleigh, North Carolina to Kansas City in August.
Jason Hartman: Fantastic. And tell us, you use the acronym AAPL, the history of it just quickly and what the vision in the world it feels.
Larry Muck: Yes. AAPL was formed in about four years ago by four guys that were involved in the industry from various aspects: an attorney, CPA, portfolio examiner and a private lender. And their idea was to help raise the standards within the industry and to develop a brand really that could be used by private lenders to say, hey, we’re good lenders, we belong to the association and therefore, we’re very trustworthy. We all know that in this pace, there are people that are predatory lenders and the association was formed really to begin to emphasize the educational aspects of private lending, to bring better knowledge and to raise standards in the industry. We got involved in the association this summer, made a capital investment to bring fulltime staff positions to it and to really work on building the value proposition of the association. So we are in the midst of working hard to identify private lenders and to begin to build that network of people across the US that really are both vendors to that space and investors and then the private lenders themselves.
Jason Hartman: So the members would be private lenders, certainly not borrowers. They are not going to join the association. But the private lenders would be the members and then I assume, different people that provide different tools to private lenders and so forth. What are the membership fees?
Larry Muck: Well, we’ve restructured our membership fees. We have $400 minimum membership, $800 for a premium membership and $1600 for corporate membership. We’re looking – we continue to review that membership structure because frankly, our goal is to get to the point where we have over 500 members and then beyond that over the next year or so. We’ve got a long way to go. We’re at about 120 to 130 members now, but we’re working at it fulltime.
Jason Hartman: Right, right. So it’s a pretty small association, just 120-130 members but how do you estimate them? I mean this is probably impossible to really know. What do you estimate as the number of private lenders out there in the country? I mean, are there thousands of them? Are there millions or I know there’s thousands. Are there hundreds of thousands? Are there millions of them? Just anybody who makes a loan. And you know, I assume we’re always talking about secured by real estate in this conversation?
Larry Muck: Not necessarily. We principally represent – the lenders in our association are principally commercial lenders. And I say that we don’t have many mortgage lenders that are doing owner occupy – the laws related to that are fairly owners.
Jason Hartman: Right, right. It is investor property that they’re financing because they don’t have all the legalities of these homeowner oriented laws and the predator lending laws. In other words, when you lend to an investor, the law makes something of an assumption that the investor is a borrower and knows what they’re doing and can protect themselves. Will that be . . .
Larry Muck: Exactly. We do have members that are doing larger deals like commercial loans, building loans, office buildings, that sort of thing. But the bread and butter is that lender that’s looking into the residential space. Again, we hope to expand the definition and draw in other parties to the association.
Jason Hartman: Let’s talk about why someone would like to be a private lender, or I mean, when you can run a whopping two-tenths of a percent in a bank, why would someone want to fool around with this, of course, I’m being sarcastic.
Larry Muck: Well, of course. I mean, the private lenders do get a much better return than you can get almost anywhere. If we look to the future, where are people going to put their money? Are they going to bet on the stock market for the next four or five years with the debt bubble that we’ve been building? Or are they going to be in the bond market? It’s really hard to see any kind of positive returns in those asset classes.
Jason Hartman: Couldn’t agree more.
Larry Muck: . . . for fifteen years.
Jason Hartman: And don’t forget to mention though that in those asset classes, you have no control with being a private lender, you’re a direct investor. I mean, you exert direct control over the investment, the choices, and – you know it’s not hard to learn. I mean, this is not a complicated thing. You don’t have to know how to evaluate a business which is an incredibly complex creature with so many moving parts. And that’s what you do as a stock investor, really, and then of course bonds have massive inflation risks, I mean, I wouldn’t touch bonds in this world nowadays. It’s just too risky. But the hard money loans are private loans – can be short-term and you know, I think they offer some great opportunities. And again as I mentioned before we started recording, they’re my second favorite investment, my first being actually owning the property itself but the thing I love about the lending is it’s just very streamline, it’s just very simple.
Larry Muck: Right. And, you know, your listeners know this as a fact that when we got up to 70% homeownership in this country, we knew that wasn’t sustainable. And now, the world thinks that are going to trend are that we are becoming a much greater rental society than we ever have been in the past. And so, homeownership, who knows where that will settle at, but there are tons of opportunities for people to get into this business and frankly, there are more tools available now to support investors, lenders across the country that . . .
Jason Hartman: Talk about some of those tools, if you would, what are they?
Larry Muck: Well, I’ve met a lot of people over the past couple of months as I’ve gotten very involved in this industry. It’s like as of next year, I’m a 30-year lender, I was in banking for that period of time before I came to the association. But, you know, we have – one of the ones I was mentioning to you was a real property management franchise system that is really putting tools in the hands of people. They have GPS tracking tools for your maintenance guy so that you know exactly how long were they at an address and for those in the managing properties, for remote investors or out of market investors, they offer an opportunity for you to prove what it is that you’re doing with your investment.
Jason Hartman: And that’s great on the management side but, you know, anything on the lending side to make lenders safer to reduce risk property evaluation tools. Of course, we’re all familiar with the stuff that’s available just kind of publicly, everybody knows about _____ [00:50:39] base and _____ [00:50:40] and things like that. You know, there are some great research opportunities on the Web of course, better than we ever had in the past but are there some specific tracking tools or evaluation tools that your association is using and recommending?
Larry Muck: Well, we’re working with a company by the name of _____ [00:50:57]. In that space, they really own that space providing critical data to property managers in terms of what the rents are and they’re practically useful when you’re looking at buying properties. We’re also working with another company that is rolling out of tool at our annual conference. They provide a nationally validated risk profile for investment properties. As a matter of fact, these guys are private lenders themselves and were using this tool to evaluate risks and they have now really developed that tool to be rolled up to other investors and lenders that want to use it to evaluate the situations that they’re getting into. Our lenders tend to be local market, people although some are starting to branch out into other markets and as they do that, they need some of these evaluation tools to be able to fair out the risks.
Jason Hartman: Sure. Absolutely, absolutely. The problem with being a local market investor, you might not live in the right place and even if you do, you won’t be diversified so that the challenge.
Larry Muck: Exactly. And so – you know, it’s re-taught, you know, more and more people are beginning to marry up in this industry. You have turnkey providers that are looking – that are soliciting investors becoming fund managers themselves. Also, you have an expansion of people that are wanting to get into this lending association for people that are looking to getting into lending, we could network you with guys that have been doing it for a long, long time and are professionals. And that’s really one of the major benefits of joining the association is to network with professionals from across the country that not only can help you from an educational standpoint but will also enable you to push deals to each other in different parts of the country.
Jason Hartman: So you have an event coming up in Las Vegas. When is that, what is the price and how many people do you expect?
Larry Muck: The event is at Caesar’s Palace at Las Vegas from November 4th through November 6th and you can read all about the event at www.aaplexpo.com and that’s our event Website. We’re expecting in the neighborhood of 150 to 175 people. We have very high quality vendors to the private lending industry that can be there as well as mortgage brokers, private lenders. We have a number of attorneys coming and if you doesn’t want to get an attorney and get advice from them, they didn’t have to pay for it at the conference so we have a wide variety of people. This is — I will make clear that in this – at this event, this is not a pitch fest, this is an educational event and it’s not about selling banks, it’s not about selling at the back of the room, it’s truly an educational network event. We have a keynote speaker by the name of Mark (Clobbery) and most people probably don’t know him but he is with the (Care) Institute and is the director of banking regulation studies. He has worked on the (Sand) Banking Committee, he was a staff for the National Association of Realtors and the National Association of Home Builders and he would be at our reception on Sunday evening and then giving the keynote address on Monday. But I will urge anybody that would want to come to the conference to get an absentee ballot because we are going through election day on Tuesday.
Jason Hartman: Good stuff. Well, hey, thank you so much and I believe you gave out the Website, you want to just quickly mention the Website again?
Larry Muck: Sure. It’s www.aaplexpo.com.
Jason Hartman: Fantastic. Well, Larry, thank you for joining us today.
Larry Muck: OK, thanks. (Top image: Flickr | gareth 1953 At Home Recovering)
The Jason Hartman Team
Transcribed by: Renee
